M. Suresh Sundaresan
Growth Options in General Equilibrium: Some Asset Pricing Implications
Coauthor(s): Julien Hugonnier, Erwan Morellec.
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We develop a general equilibrium model of a production economy which has a
risky production technology as well as a growth option to expand the scale of the
productive sector of the economy. We show that when confronted with growth
options, the representative consumer may sharply alter consumption rates to improve
the likelihood of investment. This reduction in consumption is accompanied
by an erosion of the option value of waiting to invest, leading to investment near
the zero NPV threshold. It also has important consequences for the evolution of
risk aversion, asset prices and equilibrium interest rates which we characterize in
this paper. One interesting prediction of the model is that we get time varying
risk aversion and equity returns by virtue of the presence of growth option. We
also find that the moneyness of the growth option is the key factor which determines
the extent to which the book to market ratios will influence the conditional
moments of equity returns.
Sundaresan, M. Suresh, Julien Hugonnier, and Erwan Morellec. "Growth Options in General Equilibrium: Some Asset Pricing Implications." Columbia Business School, March 2005.